Katrina and Bankruptcy: Who is the Least-Cost Bearer of the Risk

Many, many people will not be able to meet their financial obligations as a result of Katrina and its aftermath. Major automobile credit arms have said they will allow borrowers to defer monthly payments for at least three months. Many employers are offering zero interest loans. I am guessing that others will have similar policies.

But after that, what? And what about those not so fortunate in their choice of employers or lending agencies?

Representative Sheila Jackson Lee

has announced that she and other lawmakers will introduce legislation Tuesday, when Congress reconvenes, to protect devastated families and small businesses from penalties in the Bankruptcy Abuse Prevention and Consumer Protection Act, scheduled to take effect Oct. 17.

This charitable gesture raises the question of, well then, who should bear this risk? Should we expect lenders to have anticipated the risk that the area would be devastated and to have built a premium into their interest rates? Should lenders have required that borrowers have hurricane and flood insurance (and suffer the consequences if they didn't)? Should lenders have required that borrowers obtain "interruption-of-business" or loss-of-income insurance?

We might answer "yes" to that set of questions if it makes sense to hold the lenders responsible for monitoring the situation. They, in turn, would either impose responsibility for insuring against non-payment onto their borrowers or incorporate risk assessment and risk-rating in their decisions about the interest rate charged on the loan.

Another option might be to hold the borrowers responsible. But, as with all contractual situations, if the lenders can bear this risk more efficiently, most borrowing/lending contracts would adjust, one way or another, to take these risks into account.

What Representative Lee seems to be suggesting is one of two things. The first possibility is that she wants to impose this risk on lenders. Doing so will simply have the effect, in the future, that all lenders will require all types of insurance from the borrowers.

A second possibility, however, is that Lee thinks another group should be asked to bear these risks. This group is the taxpayers in general. And I wonder under what conditions this might be desireable. Surely it is more efficient to have the parties to the borrowing contract assess and assign the risk.

The only condition under which I can think that we might want taxpayers in general to bear some of this risk has to do with altruistic concern for both the borrowers and lenders. In times of disaster, we might want to require that everyone pitch in and help. The only problem with this approach is that it does not induce people to take care in their future decisions about risk-taking and risk-assignment.

Update: John Chilton points out in a comment that Becker and Posner also address this topic.